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On Our Radar

How Prime Makes Amazon Profitable

For all the money Amazon.com funnels into Prime -- a growing Instant Video library, the addition of music streaming, exclusive products, and, of course, shipping costs -- it may be the only thing enabling Amazon's retail operation to make a profit. And I'm not talking about the fact that Prime members spend more than non-members. Granted, the program wouldn't make sense if they didn't. I'm talking about the fact that Prime subscription revenue is what tips Amazon's operating profit from the red to the black.

It's the same business model followed by warehouse clubs like Costco . Costco gives us the benefit of breaking out its revenue into merchandise and membership. Last year, membership revenue accounted for 107% of net profit. Yes, if Costco didn't have any membership fees, it wouldn't be profitable. And Amazon has the opportunity to do the exact same thing, except on a much larger scale.

What does Amazon look like without Prime?Amazon won't tell us how many Prime subscribers it has worldwide, which makes the math fuzzy. But a couple years ago, Amazon all but confirmed that it had 20 million Prime members worldwide when it used the language "tens of millions of members." In 2014, it told us Prime membership grew 53%, and last year it grew 51%. So, conservatively speaking, Amazon probably has around 46 million Prime members paying $99 per year.

Revenue from Prime memberships is amortized over the life of the membership, so we must figure out the average number of members throughout the year. If we simply assume linear growth, Amazon had around 38.4 million average members throughout the year. That gives us $3.8 billion in membership revenue, significantly more than Costco's $2.5 billion in membership revenue.

Note that Costco actually generated higher net sales than Amazon. So, Costco is actually generating more sales per member compared to Amazon, even though non-members can shop with the online retailer.

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Now, the important part: Amazon's total operating profit for its retail operation came out to $2.66 billion. Revenue from our membership estimates covers 143%. Without Prime membership revenue, Amazon's retail operations result in a $1.1 billion loss.

More telling is the fact that Amazon's retail operating income grew by about $1.5 billion year over year, and Prime membership revenue grew by about $1.3 billion using the above estimates.

Why new members cause profits to riseAmazon Prime has several fixed costs and several variable costs that go along with it. Fixed costs mostly include its cost of content for Prime Instant Video. Variable costs include things like shipping and music streaming. Unlike Costco, Amazon isn't able to send Prime membership fees straight to its bottom line.

But it stands to reason that heavy Amazon users would be among the first to sign up for Prime. As Amazon goes after its next 50 million Prime members, they're likely looking for other benefits, such as video streaming, with the 2-day shipping acting as an extra bonus. In other words, new members likely cost Amazon less in variable fees than older members, so Amazon is able to keep a larger chunk of that $99 membership fee.

While Prime's membership profits aren't as cut and dry as Costco's, the memberships, as noted briefly early in this article, correlate with an increase in sales compared to non-members. That helps Amazon recover the costs of Prime. Even if newer members shop less than older members, the difference is offset by lower shipping costs.

As such, each new member brings with them some amount of revenue that practically goes straight to Amazon's bottom line. And with Prime memberships growing at a clip of 51% year over year, it seems there's lots of room left to grow and make Amazon's retail operations even more profitable.